Photo: Michael M. Santiago/Getty Images
The economy is going to get better before it gets worse. Or so various indicators would seem to suggest.
On the one hand, the U.S. is currently seeing a simultaneous decline in inflation and increase in employment. In December, American firms expanded their payrolls by more than expected, adding 223,000 jobs to the economy. At the same time, consumer prices actually fell by 0.1 percent last month. The fact that prices moderated even as jobs multiplied has spurred hopes for a “soft landing” — which is to say, for the U.S. economy to achieve stable, 2 percent inflation without ever slipping into a recession. Historically, it has usually taken an economic downturn to end a sustained period of high inflation.
For now, though, Wall Street’s investors and financial analysts are betting that this time won’t be different. Bond markets are implicitly predicting a recession by the end of 2023. In recent surveys, most economic analysts have concurred with that assessment.
But Jon Turek is not one of them. Founder of JST Advisers and author of the Cheap Convexity newsletter, Turek believes that the U.S. economy will likely grow throughout 2023. And though he thinks that the U.S. is at risk of suffering a recession next year, he insists that a “soft landing” remains possible. I spoke with Turek this week about the tailwinds at the American economy’s back, the structural factors that may keep prices elevated in the years to come, the Fed’s playbook for licking inflation, and the macroeconomic implications of China’s reopening, among other things.
What probability would you assign to a U.S. recession in 2023 and why?
I’d put the odds on the lower side; maybe a 35 percent chance. I think that over the next six to nine months, the economy is going to be okay.
To zoom out a bit, we’ve had these different forces driving demand over the last three years. First, you had the COVID stimulus and a lot of excess savings on household balance sheets. That translated into a lot of purchasing power, which ended up kind of eroding itself by generating inflation.
Then the second driver of demand was the recovery: Everyone got their jobs back and the unemployment rate fell to a 50-year low. In the process, it also produced a meaningful amount of nominal wage growth. We’ve seen wages at their highest nominal levels in 30, 40 years in the U.S.
Now, I think a third demand impulse is emerging, which is actually the cooling of inflation. We’ve seen these bullwhips where used-car prices shoot up and then come down very quickly. And I think we’re starting to see that in the rental market. And it’s also happened with gas and commodities. And the effect of disinflation in rents, gas, and car prices is an increase in real incomes.
Put differently, the prices of used cars and rental housing shot up to a point where the prices themselves started to reduce demand, which led to falling prices. And then, at the same time, global oil prices cooled off. Now, consumers are spending a smaller fraction of their income on the essentials of housing, transport, and energy, which has left them with more money to spend on other things. So disinflation in some parts of the economy may end up feeding demand and inflation in other parts. Is that right?
Yeah, I think that’s probably right. It’s also just this dynamic where prices got so out of control that the Fed’s tightening of financial conditions led them to normalize. I think that factor has played out with both core goods and housing.
Now, is this new demand impulse going to keep growth going for two years? Probably not. But at least over the next six to nine months, I think the combination of much lower gas prices than a year ago and possibly lower rent than a year ago puts a tailwind behind consumption. At the same time, on the corporate side, I think we’re going to see cost relief as supply-side pressures come down. And both those developments should help the economy weather further Fed tightening in the near term.
Would it be accurate to say that the increase in real incomes has reduced the probability of a recession this year, while increasing the risk of one next year? After all, it might be hard for the Fed to hit its 2 percent inflation target while real incomes are rising. So that could lead the central bank to tighten financial conditions even more aggressively.
Yeah. I think that over the long term, this dynamic will push the Fed to stay at these higher yields for longer. And then the question that will arise in the next 19 to 24 months is: How long can the real economy take 4 or 5 percent interest rates? Which is to say, real interest rates (after accounting for inflation) of 2 percent? Can the economy absorb that over a two-year time horizon? And I think that’s unknown.
What’s driving inflation in the U.S. context? Over the past couple years, there’s been a lot of debate about whether we should understand rising prices as primarily driven by temporary disruptions to supply chains or by excessive demand, meaning by a level of demand that the economy could not meet, even after supply chains fully healed from the pandemic.
I think there’s an element of both. The very high inflation that we saw — the 8 and 9 percent ratings — came from things that were not sustainable. Clearly, owner’s equivalent rent wasn’t going to rise annually at 12 percent in perpetuity. Gas prices above $5 a gallon were not necessarily indicative of a new norm, and certainly weren’t going to accelerate another 100 percent from there. So I think there were elements on the margin that were transitory. But I think we were entering — or are entering — a higher inflationary period almost regardless.
I think that COVID and the fiscal support that accumulated since then has definitely played a big role. It was hard for the economy to catch up on the supply side when households had built up so much savings. And then that issue was compounded by the fact that, in the post-COVID world, wage growth has been very strong. So there hasn’t really been a demand slowdown that could allow supply to catch back up. Which is why the Fed has had to come in and tighten so aggressively to assist that rebalancing.
Is it still possible that the U.S. will be able to get back to price stability without entering a recession? And if so, what would need to happen to bring that about?
So, I think the optimistic scenario is very much alive. And I think the playbook for achieving that is the one that [Federal Reserve chair] Jay Powell has laid out. The Fed is concerned with the very essence of trend inflation, or what John Williams of the New York Fed calls the innermost part of the inflation onion, which is inflation minus food, energy, and owner’s equivalent rent.
And they consider that the best measure of inflation because food and energy prices are inherently volatile, while rental prices are a lagging indicator (since a lot of people’s rents were determined by market conditions months ago, rather than today)?
Yes. And when you strip all of that out, the best predictor of the remaining inflation is wage growth. So the Fed is aiming to reduce wage growth without a material rise in unemployment. Historical precedent suggests that that isn’t possible. But the Fed thinks it might be this time because the imbalance between labor supply and labor demand has grown historically out of whack. Right now, there are something like 10 million unfilled job openings, and an unusually high ratio of job openings to unemployed workers. So, the Fed thinks that, if it can cool demand enough to bring that ratio down to normal levels, then that alone might bring wage growth down to 4 percent annualized rather than 5 percent, even without an increase in the unemployment rate.
In other words, the historic number of job openings serves as a kind of cushion against mass layoffs since, in the event of falling demand, companies can start by slowing hiring and eliminating unfilled positions rather than laying off existing workers. And then, if there are fewer job opportunities available to workers, workers will moderate their wage demands.
Yeah. And lower wage growth is key for two reasons. First, if people aren’t getting 5 or 6 percent wage increases every year, then that directly moderates demand. Second, it also helps the Federal Reserve to trust that whatever disinflation we’re seeing will be sustainable.
In recent commentary, the Fed has explained that, even if inflation falls toward their target range, it’s going to be hard for them to trust that price growth is stable if nominal wage growth remains high.
But if wage growth comes down to normalized levels — say 4 percent or a little under that — then the Fed will have confidence that inflation is not going to go back to 4 or 5 percent. And at that point, they’d let up on financial conditions. So that’s the playbook for the soft landing that the Fed is trying to engineer.
And I think it’s possible, though the empirical evidence does suggest that a soft landing is very unlikely once inflation crosses 5 percent.
You recently wrote that one of the bigger questions hanging over the global economy is how China’s reopening will impact inflation. The world’s most populous country is finally bringing its economy back online after its long experiment with zero COVID. Do we have any indication yet of whether this will increase inflation on net (since China’s 1.4 billion people will now be using more fuel, and its factories will be demanding more commodities) or reduce it (since one of the world’s largest manufacturing hubs will finally return to full capacity)?
I don’t think we have a sense yet. China isn’t going to see a boom in consumption on par with what we saw in the Western world when we relaxed pandemic restrictions. There’ll be pockets of it that will be very immediate, such as higher demand for travel. But China’s households save at very high rates. And the reopening comes against a broader economic backdrop characterized by a struggling property sector, which is saddled with high levels of debt. So all that makes it hard to see how we get a massive boom from China’s reopening.
But it is nevertheless another big buffer to economic activity around the world, especially during the first half of the year. In terms of inflation, it is hard to see which dynamic wins out between domestic Chinese consumption triggering another wave of commodity inflation versus Chinese production reducing global costs.
For the U.S., the happiest of all scenarios would be one in which we brought the economy into balance by expanding supply instead of reducing demand. If we could somehow increase the productive capacity of the economy — whether through an increase in labor-force participation or gains in productivity — we might be able to have our 5 percent nominal wage growth and price stability too. And back in 2018 and 2019, we actually saw demand create its own supply to an extent, as strong labor-market demand attracted workers back into the labor force. Is there no hope for that sort of outcome?
I think that productivity should improve. But it’s coming from very negative levels. So I think we should see improvements, especially since we had a very unusual year in 2022, when the economy created 4 million jobs yet barely grew. That is a lot of negative productivity. And I think a lot of it is a byproduct of having to put the economy back together following the pandemic. Firms needed to restaff and adjust to higher than expected demand. Now the economy is getting into a better balance, and that should lift productivity.
Is there scope for a big productivity increase? It’s hard to say. It doesn’t look like labor-force participation is going to rise substantially. And we’re on the flip side of a globalization period; right now, the economy is de-globalizing, which will create a lot of inefficiency and redundancy. So it’s hard to say where the big productivity boom is going to come from, even though we do seem to be in a broader capital-expenditure cycle.
It’s possible that the supply side can help as the economy begins to rebalance in a more sustainable way. But I think the Fed is going to have a hard time banking fully on the supply side given that a lot of the structural trends are just not very favorable at the moment.
On that point: Analysts from Allianz and BlackRock have recently argued that we’re entering a new economic era, one that is structurally more vulnerable to inflation. They note, as you just did, that globalization is giving way to “friendshoring”: Instead of trying to make supply chains maximally efficient, nations and firms are balancing efficiency against geopolitical risks. And that increases the overall cost of production and thus prices.
Meanwhile, the green transition represents another persistent source of inflationary pressure. Building out clean-energy infrastructure will commandeer a lot of labor and resources. And there is also a risk that capital investment in fossil-fuel production will fall faster than clean-energy production rises, leading to scarcity and thus higher energy prices. Finally, throughout the developed world, populations are aging, which reduces labor supply more than it reduces labor demand, since the retired consume goods and services but don’t produce them. Do you buy that narrative?
I broadly subscribe to that, yeah. Although I think there’s a flip side, right? At least in the early stages of these trends, there’s a real benefit to growth. Friendshoring is inefficient, but it also increases capital investment. And the green transition will also spur big capital expenditures.
In a way, what’s playing out now is the reciprocal of the previous 40 years of economic development. With globalization, we lost a lot of growth impulse but enjoyed higher productivity. Now we’re flipping to higher growth and lower productivity. So both nominal GDP and inflation are going to be higher.
Which isn’t to say we’re entering a boom period. But I think something like 5 to 6 percent nominal GDP growth could be a fairly regular occurrence over the next five years or so, which was very atypical from basically the early 2000s to 2021.
It seems to me that the structural forces that are reducing productivity — like the aging of the population — might be more visible than other forces that could potentially increase it. We can say with near certainty what the demographic structure of the U.S. is going to look like in ten years. But it’s hard to anticipate technological breakthroughs. So is it possible that BlackRock’s outlook is overly bearish with regard to inflation, since it doesn’t take into account the potentially deflationary impacts of, say, advances in artificial intelligence?
It’s certainly possible. I’m just looking at where we are right now. It’s almost ridiculous to make guesses of where we’ll be in five years. In terms of the big structural forces that are impacting the economy at present, they are on balance promoting higher nominal GDP and inflation relative to the 2010s environment.
Of course, it’s entirely possible that something unforeseen will change the outlook radically. There could be another announcement about a breakthrough in fusion energy, one that is actually actionable. Human ingenuity has surprised us in the past.